Industrial and Office Park Outlook

Members of ULI’s Industrial & Office Park Council discuss the recovery of the industrial and office sectors, what investors are looking for, the return of development, and other trends.

Contributing their insights are Jeffrey Barclay, managing director of Goldman, Sachs & Co. in New York City and chair of the Industrial & Office Park Council (Gold Flight); James Carpenter, executive director of capital markets for Cushman & Wakefield of Illinois in Chicago and assistant chair of the Green Flight; Jack Fraker, managing director of CBRE’s capital markets industrial practice, vice chairman within the company’s investment ­properties–institutional group in Dallas, and chair of the Red Flight; Andrew Friedman, managing director of capital transactions for Shorenstein in San Francisco and chair of the Blue Flight; and John Levy, president of John B. Levy & Company in Richmond, Virginia, and chair of the Black Flight.

How would you characterize the recovery of the industrial and office sectors, and what kind of uncertainty remains?

Jack Fraker: The job losses in this country did not hit the industrial sector as badly as they hit the office market. But because consumer spending was down, warehouse demand was down, so we had a lull in the fundamentals in 2009 and 2010. When the recession hit, everybody could quickly put the brakes on new construction, knowing that it only takes about six months to build a warehouse or distribution center. Now the economy is better, and many markets around the country have healthy occupancy levels. Some speculative construction is taking place in a handful of markets. The fundamentals are improving, interest rates are favorable, and institutional investors continue to be interested in industrial real estate.

Jack Fraker

James Carpenter: Overall, the industrial leasing market improved in 2011. In prior recoveries, small businesses led the way. In this recovery, market performance was driven by large multinational corporations with cash or access to capital. They were reconfiguring their supply chains to save money, primarily for consumer products and e-retail, and they leased modern, high-ceiling warehouses larger than 400,000 square feet [37,000 sq m]. At the other end of the spectrum, 20,000- to 100,000-square-foot [1,900 to 9,300 sq m] spaces leased to local companies and 100,000- to 300,000-square-foot [9,300 to 28,000 sq m] spaces leased to regional companies didn’t start to perform very well until the fourth quarter of 2011, and then probably due to improved prospects for employment, a moderate uptick in consumer spending, restocking of inventories, and incrementally better credit for small to midsized business, all overlaid with a current of optimism about the economy.

Andrew Friedman: In the Bay Area, office absorption is strong in many markets, particularly in San Francisco’s South of Market submarket and in Palo Alto, Menlo Park, Mountain View, and Cupertino. There has been less activity in San Jose and Santa Clara, but the prospects for 2012 are improving. Much of the leasing activity is driven by big technology firms like Apple, Facebook, Google, Salesforce, Twitter, Yammer, and Yelp. In Seattle, a dozen large companies are growing, but the big gorilla there is Amazon, which added about 10,000 employees last year, the overwhelming majority in Seattle’s South Lake Union submarket. Traditional downtown office tenants—finance, real estate, insurance, and other professional services—have grown more slowly.

Jeffrey Barclay

Jeffrey Barclay: The hottest topic for everybody in real estate right now, especially in the office sector, is job growth. Where is job growth going to come from? When will corporations that are now flush with cash start hiring? From a real estate point of view, the questions are how to respond to those companies’ needs and to what extent is conventional real estate obsolete, or at least not optimally useful. On the industrial side, the question is really much more related to trade—how the slowdown of China’s economy might influence trade patterns, how the 2014 expansion of the Panama Canal will have an impact on trade.

John Levy: What we have is a very uneven recovery, and the concept of risk is still a big issue for people. They really don’t know where they want to take risk, and there are still a lot of people who want to play both ends of the barbell: either they want to be extremely safe or very risky. The thought process is that they will lose some money on the very risky deals, but they will make enough that it will be effective.

What are investors looking for, and what is the availability of financing?

Carpenter: In the industrial arena, the typical investor in 2011 was seeking a major distribution market—Seattle, Los Angeles, Chicago, northern New Jersey, or Miami. The investor market wanted newer, fully occupied, larger distribution space in those markets, and they were willing to pay a handsome price. That resulted in significant trading of those assets in most markets. Now investors are willing to think about Class B product, provided that they stay in those major markets. That’s a function of pricing: the yields in the slightly lesser-quality product, as long as it’s well located and well designed, are significantly higher than yields for core, probably by 125 to 175 basis points. After the Class B buildings begin to trade in primary markets, Class A products will likely trade in lesser markets like Indianapolis, Nashville, Charlotte, Memphis, or Phoenix.

John Levy

Fraker: Most institutional investors are focused on the top-tier markets and are not looking as closely at industrial opportunities in so-called secondary cities. I think they are missing opportunities for slightly higher returns by not going into these secondary cities, where they could be getting a higher return by about 50 to 100 basis points. Later on, those cap rates and returns might get compressed in secondary markets, so there is a built-in profit. I’m watching closely to see when the money starts coming back into the secondary markets.

Levy: The good news for both industrial and office buildings is that the reemergence of the commercial mortgage–backed securities [CMBS] market is offering a financial alternative that has been lacking for the last four or five years. We have been able to do big deals in major cities for quite a while—­Washington, D.C., New York, San Francisco—but a good building in Nashville or Austin might have had trouble. The CMBS market is willing to provide capital not just in five cities, but in 30 or 40. In addition, there is quite a bit of money in the form of either mezzanine debt or preferred equity. The rates for mezzanine debt have come down dramatically as well.

Are you seeing signs of a return to development?

Friedman: Office development is coming back faster than people anticipated. In Seattle, there is talk of development, and one small project in the South Lake Union area just broke ground. In San Francisco, Tishman Speyer has announced plans to build two office projects in South of Market and expects to start construction in the near term. In Silicon Valley, a number of projects have either broken ground in the last 60 to 90 days or they are going to soon. I can think of three or four projects in Sunnyvale, Mountain View, Santa Clara, and Palo Alto. There are also some land sales. I know one that is expected to close at a price that is close to the peak prices reached before the downturn, and my understanding is that it’s going to be a spec development.

Fraker: For the industrial markets, Los Angeles, Houston, south Florida, central Pennsylvania, and even Salt Lake City are showing signs of life. New construction is likely to start later this year in Dallas, Chicago, Cincinnati, and Indianapolis. What’s being built are very large buildings because corporate America became very cautious and shelved its expansion projects and consolidated distribution center projects from 2009 to 2011. Now corporate America has a little more confidence in the economy.

James Carpenter

For the office sector, do trends favor urban locations over suburban ones?

Barclay: Urbanization is creating new winners and losers. New York City is a great example. The most active markets in New York are not necessarily in the traditional big corporate markets. The best example I can point to is Chelsea and the meatpacking district in New York. Two years ago, Google bought a building there, and ever since then the desire to be near there has been tremendous among tenants. It’s possible that corporations will have less appetite for suburban office parks, or that some edge cities will benefit and some of the more remote locations will suffer. This trend is likely to lead to more adaptive reuse. The old buildings, like the one Google bought in New York, are extremely suitable for today’s technology.

Levy: There is no question that there is a move to hipper space—unfinished ceilings, open plans, ping-pong tables, Wi-Fi everywhere. Today’s workers may take up a little less space than they did in traditional offices, but now they have different needs. They want a car wash or a gym in the building; they want Wi-Fi in the lunchroom. But those spaces don’t necessarily have to be downtown. Silicon Valley is pretty hip, after all.

What other trends are shaping the industrial and office park sectors?

Levy: The Ben Bernanke economic plan is actually working. Right now, if you open a money market fund, you might get 10 basis points a year. Not too long ago, you could make 3 to 5 percent interest. With the Federal Reserve policy now, there is no reward for parking your money. You have to invest it, and real estate is generally thought to be a relatively safe, high-yield investment. By keeping rates very low, Bernanke has forced investors to look for and accept some risk.

Andrew Friedman

Carpenter: E-commerce is the dominant force in the industrial sector because it’s driving so much of the changing demand in retail. The e-retailers are leasing big buildings. Amazon is the bellwether: they leased a couple million square feet in Phoenix last year. In Louisville, which is a UPS hub, the Zappos.com shoe company has 900,000 square feet [84,000 sq m] and is adding more space every day. The large e-retailers are all taking space close to these major logistics hubs for overnight shipping.

Fraker: The biggest change in the industrial sector is that these buildings now are designed with lots of trailer parking on site. It requires more land, but corporate real estate managers want to get maximum utility out of the site. In some cases, the trailers are used for storage. Also, there is a move to make more warehouses environmentally oriented and to obtain LEED [Leadership in Energy and Environmental Design] certification, with features such as on-site water retention, reflective roofs, and clerestory windows to bring in natural light.

Barclay: The amount of office space per employee is shrinking. Technology such as the iPad has been a game changer. People can be much more productive in much less space. Even a few years ago the security concerns about wireless communication systems in offices were almost prohibitive, and now wireless systems are everywhere, allowing people to be productive from anywhere they want to be. Office tenants are looking for spaces where their employees can effectively collaborate. They’re moving more toward teams: people work with one set of people on one project and another set of people on another project. Tenants want common areas where people can catch up over coffee or work out, informal meeting spaces distributed throughout the space. There’s a major workplace trend toward breaking down the boundary between work and play.

Friedman: Workplaces are getting denser. The old rule of thumb was one employee per 250 square feet [23 sq m]. Now, especially in the tech world, in an open-plan work environment, one employee for every 125 to 140 square feet [12 to 13 sq m] is more common. Companies are also providing more informal meeting areas, lounges, and amenities such as high-quality food and exercise facilities. As a result, tenants are favoring larger floor plates with better window lines. That gives them the ability to efficiently accommodate a dense work environment, provide multiple amenities on the same floor as the workspace, and give employees the flexibility to quickly form project teams as needed. Now a lot of other industries with younger workers, whether media companies or entrepreneurial finance companies, are also seeking these creative kinds of spaces.

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